Iranian Economic Review, Vol.14, No.

24, Fall 2009

The Impacts of Unified Exchange Rate System on

Domestic Price in Iran

Ali Reza Kazerooni

Majid Feshari

Abstract T he main purpose of this paper is to examine the impact of exchange rate unification policies on the domestic price in Iran using a co-integration approach between 1971and 2002. For doing this, a weighted average of exchange rate under the multiple exchange rate regimes is used as a proxy for the unified exchange rate. The impact of this unified exchange rate on the domestic price alongside with other variables is evaluated by multivariate Johansens co-integration technique. The main finding indicates that the unified exchange rate has a positive effect on the domestic price in Iran. In other words, the move from multiple exchange rate system to unified exchange rate maybe accompanied with inflationary pressure. Keyword: Foreign exchange rate unification, Iranian economy, Co- integration test, Domestic price.

Associate Professor, Economics Department, University of Tabriz.

Ph.D. Student of Economics, University of Tabriz.72/ The Impacts of Unified Exchange Rate System on Domestic Price.

1- Introduction In this paper, we analyze the impact of a change in the exchange ratesystem-from the multiple exchange rates to the single rate- on the Iranianmacro economy. The exchange rate unification has been achieved by severalless developed countries (LDCs) in the past. The experiences of some ofthese countries like Turkey, Venezuela, and Argentina have been successful.Here the focus is on the exchange rate unification implemented by theCentral Bank of Iran in early 2002. We ask, to what extent has the adoptionof a single exchange rate after the exchange rate unification in 2002 affectedthe domestic macroeconomic variables. Specifically, does the exchange rateunification accelerate domestic inflation? It is our objective to answer thisquestion and provide some policy implications as well. Prior to the unification, Iran was under a multiple exchange ratesystem. The exchange rate unification policy was part of a broad structuraladjustment, which started during the second Iranian economic planning(1995-99). These changes were in response to the large fluctuations in theexchange rate since the 1979 Iranian revolution. Furthermore, during thistime, the exchange rate was subject to a large number of shocks, overallresulting in a devaluation of the domestic currency against major foreigncurrencies. To analyze the impact of the adoption of a single currency we constructa multivariate VAR model based on the extended QTM1. Then, by applyingthe Johansen co-integration technique, the long-run relationship between thedomestic price level and exchange rate alongside other relevant variables isestimated. The variables that we are considering are exchange rate, GDP,money supply, oil price and domestic price level from 1971-2002. Although we do not have data on the unified exchange rate for the timeperiod, we are nevertheless able to analyze the impact of a single exchangerate on the economy through the use of a weighted average of official andparallel exchange rates as a proxy for the unified exchange rate. Before theunification of foreign exchange market in 2002 by floating exchange rate,five types of exchange rates have existed in the Iranian economy. One ofthese was the parallel exchange rate, which was a black market exchange

1- Quantity Theory of Money.

Kazerooni, Ali Reza & Majid Feshari. /73

rate. After abandoning the multiple exchange rate system in 2002, all of theexchange rates more or less approached a single rate the parallel exchangerate. That reflects the managed floating exchange rate in the foreignexchange market today. Since 2002, the new exchange rate has been thesame as the parallel exchange rate. The remainder of the paper is organized as follows. In section 2, themain features of Iranian economy and its foreign exchange rate developmentare briefly discussed. This is followed by a review of previous studies. Thetheoretical framework as well as econometric methodology are explored insection 4. In section5, the stationary test of variables is tabulated.Moreover, the results of co-integration test and estimations are presented andexplored. Lastly, section 6 concludes the paper and presents some policyimplications.

2- The Iranian Economy and Its Exchange Rate Developments

Like the other oil exporting counties, the major challenge facing Iranianeconomy is its overwhelming dependence on the petrodollars. According toa 2002 IMF report, the share of oil in the total government revenues variedbetween 40 to 64 percent during 1998-2002 and the share of oil in totalexports was in the range of 67 to 83 percent during the same time period.These figures are presented in Table 1.

Non-oil exports 3185 3941 4181 4565 5379

Oil and gas exports 15544 10048 16322 23261 18724

Source:IMF(2002), Islamic Republic of Iran:Selected Issues and

Statistical Appendix, Country Report NO.2/212, pp.38-39.74/ The Impacts of Unified Exchange Rate System on Domestic Price.

A major portion of the Iranian oil revenues is transferred to different

segments of the Iranian economy through subsidies that range from implicitsubsidies on the price of different consumer goods, such as bread, sugar, andpetroleum, to direct subsidies like rationing coupons on consumer goods.According to the IMF report, total subsidies through the consumer goodssuch as fertilizer, sugar, wheat, milk, cheese, rice and vegetable oil has goneup from 1.9% of GDP in 1998 to 2% of GDP in 2002.1 It should be notedthat government subsidies were not limited to consumer goods, but alsoincluded administered foreign exchange rate (to the industrial units) andbank interest rate. Another characteristic of the Iranian economy is its heavy dependenceon import goods, especially intermediate and capital goods. Table 2 indicatesthat more than 85 per cent of the Iranian imports constitute intermediate andcapital goods, which are essential in the process of industrial production.Furthermore, 0.37 dollars worth of imported

Total 14196 14323 12683 14347 17626

Primary and intermediate goods were needed to produce 100 rials of

non-oil GDP in 1983. In contrast, the import content was more intensive inthe manufacturing sector. At the same time, it was essential to import 1.81dollars of primary and intermediate goods for per 100 rials of value added in

1- IMF, Country Report, p. 31.

Kazerooni, Ali Reza & Majid Feshari. /75

the manufacturing sector.1 Consequently, the exchange rate unification by

level of floating exchange rate in the market can have stagflationary impacton the economy, especially in the manufacturing sector. Now we look at the economic performance of the Iranian economybetween 1970 and 2002. According to figure 2.1, both Iranian GDP andGDP per capita growth rates have declined in the post revolutionary period,especially during the years immediately after the revolution, indicating therehas been a trade-off between economic growth and more equitabledistribution of income as mentioned before.

20

15

10

-5

-10

-15

GDPGR GDPPCAG -20 1975 1978 1981 1984 1987 1990 1993 1996 1999

Figure 1: Iranian GDP Growth Rate Versus GDP Per

Figure 2-2 indicates that declining GDP per capita in the post-revolutionary period has caused the consumption share of income toincrease.

In figure 2-4, there has been a correlation between trends of money

growth and inflation. However, in some years like 1995, the inflation is more Kazerooni, Ali Reza & Majid Feshari. /77

likely explained by the parallel exchange rate surge rather than by the moneygrowth. Moreover, the trends indicate the average growth rate of money andinflation has been 20 and 21 percent.

2-1- The Foreign Exchange Rate Developments in Iran

A study by World Bank on the eight developing countries, includingArgentina, Ghana, Mexico, Sudan, Tanzania, Turkey, Venezuela, andZambia has revealed that in case of Argentina, Mexico, and Venezuela, theemergence of the parallel foreign exchange market1 has for a temporaryperiod been in response to the severe balance of payments crisis by a drop inoil price, massive capital flight, and debt crisis by delaying macroeconomicadjustments and avoiding the domestic inflation. In second group countries,mainly African countries with unconvertible currencies, a gradual growingof the parallel exchange markets mainly reflect tightening control on capitalaccount transactions at the official exchange rate and to some extentnumerous transactions in current account by government which presumablyhave resulted from fiscal deficit and domestic inflation. The main objectiveof creating parallel markets has been to preserve the exhausting foreignexchange reserves and to maintain the over-valued domestic currencies2. The size of parallel exchange rate premium depends on the governmentcontrol on capital account. With respect to foreign exchange market developments in Iran, underthe Breton-Woods system (1944-1973), the parity rate between US dollarand Iranian currency, rial, was pegged; there was no significant marginbetween the official exchange rate and market rate. With skyrocketing worldoil price in the early 1970s, the exchange rate of rial against major foreigncurrencies was relatively stable, even after the collapse of the Breton-Woodsagreement in 1973.

is a market determined exchange rate witch coexists with the official market exchange rate.2- Kiguel & OConnell, 1994, p.23-24.78/ The Impacts of Unified Exchange Rate System on Domestic Price.

Up to the 1979 revolution, a review of the US dollar exchange rate in

terms of rials indicates that the rate has been relatively stable in the blackmarket. Moreover, since the Iranian government has a monopoly power overthe oil export and is a major supplier of foreign exchange in the domesticmarket, it is obvious that the world oil price as well as the petrodollarsderived from the oil exports can have a profound effect on the foreignexchange rate equilibrium in Iran. It means that any external oil price shockcan destabilize the foreign exchange rate. In the period immediately after the 1979 Iranian revolution, a heavyrestriction was imposed on the transactions of capital and current accounts atthe official exchange rate by the government in order to deal with the capitalflight overseas. Allocation of foreign exchange at the official exchange ratewas just limited to the government transactions for importing the essentialfoodstuffs and intermediate inputs for the public-related enterprises. Theforeign exchange for importing non-essential goods had to be provided fromthe black market. In this way, a parallel foreign exchange market graduallyemerged and a dual exchange rate system was developed. Overtime, the gapbetween parallel exchange rate and official rate has widened (Figure 2.6).This widening gap can be attributed to several factors. First of all,uncertainties surrounding the private property rights, confiscations andnationalization of the private properties in the early years of the revolutionhave led to the huge flight of capital out of Iran (outflow of capital during1979 and 1980 has been 6884 and 843 million rials respectively).1 Inaddition, Iran and Iraq war and reduction in oil exports and its price caused ashortfall in the oil earnings. All of these factors have put a heavy pressure onthe parallel foreign exchange market; consequently, the parallel ratepremium over official rate during time has increased, indicating a highdomestic inflation which was caused by strong monetary expansion. In 1985,a major oil price shock in downward direction in world has reduced sharplyIranian oil revenue. As a result, the premium of the parallel rate reached to

Figure 2.6: the comparison of the official exchange rate (OE) with the Parallel exchange rate in Iran (FE), 1961-2000,(dollar in terms of rial). Source of data: Central Bank of Iran

According to figure 2.6, the gap between parallel exchange rate andofficial rate has widened since 1979. It has been argued that the main beneficiary of the overvalued domesticcurrency has been the industrial sector; especially, all of the large industrialenterprises which were in control of government, had access to the cheapforeign currencies (preferential exchange rate) to import intermediate andraw material inputs. These large manufacturing units have produced about86 percent of the industrial output. Moreover, the large modern enterprises,to a large extent, depend upon imports. The share of imported primary inputs(1983) in total inputs and output of the large industrial units has been 54%and 28.2 % respectively. Any attempt by the government to unify themultiple exchange rates will end the preferential exchange rate for the

1- The premium of the parallel exchange rate is calculated as Premium= ((FE/OE)-

1)* 100.80/ The Impacts of Unified Exchange Rate System on Domestic Price.

industrial sector. As a result, industrial units have to pay at a higher

exchange rate to import the intermediate inputs. It means the cost ofproduction for these producers will go up and eventually they will lose theircompetitive edge and cut production (exchange rate through inflation). Just before the year of 2002, there was a multiple exchange rateregime in Iran. Under this regime, the government could control the demandfor the foreign exchange by rationing the foreign exchange at the variousadministrative exchange rates. As a matter of fact, five different foreignexchange rates existed which can be classified as follows: 1-The official floating exchange rate: Since October 1995, this rate was set up at the level of 1750 rails perdollar and basically used to import the essential goods, such as wheat, sugar,pharmaceuticals, and others at subsidized exchange rate by governmentagencies. This exchange rate would be reflected in the subsidized prices ofessential foodstuffs like bread and other related consumer goods in themarket. 2-The official export rate: This rate was fixed at 3000 rials per U.S. dollar from May 1995 toMarch 2000. This rate was applied to the exchange earnings of non-oilexporters. In the beginning, the merchants had to surrender their earnings tothe central bank and convert them into domestic currency according to thisrate. The exporters also had two to three months to finance their own importsfrom their earnings or transfer them to another importer. This export ratealso was applied to the imports of state-owned enterprises. From 1997 on,the exporters could trade their foreign earnings at the Tehran StockExchange Market (TSE) at a rate which was higher than the export rate. 3- The official Tehran Stock Exchange rate: By 2000, the Central Bank of Iran followed a managed floating ratein TSE and for most of 2000; the rate was less than 8200 Rials per US dollar.In this year, the official export rate was abolished. The central bank of Iran was the main supplier of foreign exchange toTSE (60 percent). 4-The unofficial negotiated rates: The commercial banks traded with one another or by their owncustomers at these rates. In 1998, the negotiated rates were at a premium Kazerooni, Ali Reza & Majid Feshari. /81

over the TSE rate, but by the end of 2000, the differences between these rates were insignificant and reflecting the transaction cost. 5- The parallel exchange rate: In addition, there has been a black market exchange rate, which immediately emerged after the Iranian revolution in 1979. After abolishing this MERS in early 2002 by the government, all rates more and less approached to a single rate, which reflects the managed floating exchange rate in the foreign exchange market. The table 2.4 indicates the multiple exchange rate developments during 1998-2002 before the unification.

Some economists believe that the structural trap, which has prevented Iran from achieving its potential economic capacity in terms of efficient allocation as well as full employment of resources, is a main obstacle to its economic growth. The structural trap refers to a state in which political and economic barriers prevent reallocation of capital from low productivity firms to high productivity firms. Alongside the structural rigidities of economy such as domination of government inefficient enterprises, widespread82/ The Impacts of Unified Exchange Rate System on Domestic Price.

government interventions in the market, lack of competitiveness in the

domestic market as well as the international markets, labour law, andrevolutionary institutions, the multiple exchange rate regime has contributedto this structural trap. According to the World Bank Report, a prolongedheavy interventionist policy by the government in economy has been a mainchallenge to the economic growth of Iran.1 In early 2002, some measures ofeconomic structural adjustments, including privatization of banking systemsand the government-controlled enterprises, gradual liberalization of foreigntrade and foreign direct investment, tax reforms, liberalization andunification of foreign exchange rate were undertaken with the aim ofbreaking the structural trap. In addition, in the age of economicglobalization, the economic integration of Iran into the world economy ispossible, when it is exposed to these reforms. The multiple exchange rate regimes have been a source of pricedistortion. Based on the following arguments, the adoption of a unifiedexchange rate can be advocated.

Eliminating economic rents between private and government sectors.

Before the year of 2002, the existence of the multiple exchange rateregimes had created an economic rent between the private sector andgovernment sectors. The state-owned enterprises could receive a lowpreferential exchange rate, while the private sectors had to obtain the foreignexchange either from the black market or the government in a higher rate.This has led to an economic rent in favour of the governments firms.Therefore, the efficiency of the private sector versus government sectorcould not be evaluated clearly. The unified exchange rate policy enforced thestate owned enterprises to observe real cost of production and remove theimplicit foreign exchange subsidies from them.

1- World Bank. A Memorandum On Interim Assistance Strategy For the Islamic

Allocating the economic resources among different users more

efficiently and correcting the economic signs to the economic agents. The low exchange rate to the government sectors had distorted the priceratio of the commodities, which is critical for economic efficiency inallocation of resources. The exchange rate unification was designed toeliminate distortion in prices and correct real prices of commodities, whichwas a sign of scarcity in the economy. In this case the unification has createdan incentive for the government to purchase the goods, especiallyagricultural products, from the domestic producers rather than to importfrom outside at a high exchange rate. So, it can be argued that the policy may have anexpansionary effect on the domestic output.

Revealing the real implicit cost of importing essential goods (the realcost of scarce economic resources) in Iranian budget. The unified exchange rate was implemented at 7700 rials per dollar inIranian annual budget for the first time in 2002. It meant that there was nopreferential exchange rate of 1750 per dollar for the expenditures on theimports of basic necessities any more. As a result, the expenditures on thebasic necessities raised from 10 trillions in 2001 to 33 trillion Rials in 2002,indicating a clear picture of subsidy to the basic commodities1. As a matterof fact, it was a first step for the reforms in the structure of subsidies in Iran. A successful unification of exchange rate depends on adoption of thesuitable exchange rate regime in the post- unification period which should beconsistent with the fiscal and monetary policies of the country. For instance,in the case of Iran, which has a persistence fiscal deficit and monetaryexpansionary policies, the exchange rate should be unified by a managedflexible exchange rates or crawling pegged exchange rate system. Asmentioned before, the process of exchange rate unification in the developingnations, where the parallel exchange market has been developed temporarilyin response to the balance of payments crisis can be quick (like Argentina,Mexico, and Venezuela). This process has been slow in other countries (such

Trap, The Brown Journal of World Affairs, 2, V. IX, Winter/Spring 2003: 267-281.84/ The Impacts of Unified Exchange Rate System on Domestic Price.

as Ghana, Tanzania, and Turkey) where the parallel exchange market hasbeen active for a long time.

3- Previous Studies By using macroeconomic balance approach, Sundararajan (1999)defines the equilibrium real exchange rate (ERER) in the context ofsimultaneous equilibrium in the internal and external sectors of the economy.Through specification of influential exogenous and endogenous variables inthe external and external balances, a linkage between the REER (realeffective exchange rate) and these variables have been developed andsubsequently, estimated by co-integration approach. Bahmani-Oskooee (1996) based on the co-integration analysis and byusing annual data over the 1959-90 periods, has shown that massivedepreciation of the Iranian rial has had contractionary impact on thedomestic output. In another paper, he (1995) has used a monetarist modelaugmented with imported inflation and exchange rate depreciation toidentify the determinants of inflation in Iran. The conclusion is that inflationis not only a monetary phenomenon, but it is also a product of thedepreciation of domestic currency and import inflation. Another study as a research proposal (Salikhova, Flora) is concernedwith the exchange rate unification in Uzbekistan and its effect on thedomestic price level, following the foreign exchange market liberalization.For this purpose, a VAR model is developed with four endogenous variables,including consumer price index, money supply (M2), official exchange rateand market exchange rate. McCarty (2000) examines pass-through of exchange rates and import prices to domestic inflation in some industrialized economies by using the VAR model over the post-Breton Woods era. His conclusion indicates that exchange rate shocks have a smaller impact on the domestic inflation in most of these countries in the sample, while import price shocks are more pronounced on the domestic inflation in countries with higher import share of domestic demand. Concerning the linkage between devaluation domestic currency andinflation in less developed countries, Ahmad and Ali (1999) explain that Kazerooni, Ali Reza & Majid Feshari. /85

there is consistent evidence in Pakistan, indicating domestic price level over

time responds gradually to the exchange rate depreciation. Most studies relevant to the Iranian case, has indicated that the rise ofexchange rate (depreciation of domestic currency) has led to the inflation inthe Iranian economy. Adeli (1992) believes that by unification andcorrection of exchange rate from multiple exchange rate systems, it isexpected that inflationary pressure will appear. A study by Kandil (2004) on 22 less developed countries revealed thata depreciation of domestic currency (both anticipated and unanticipated)lowers output growth and raises price inflation. Aljebrin (2006) investigation is related to the main determinants ofinflation in developing oil-exporting countries. In this study the Johensensco-integration technique has been used to estimate the long-run relationshipbetween inflation and money growth, exchange rate, growth of non-oil GDPand growth of oil prices. The results of this study indicate that in the long-run, inflation rate depends on growth of money, growth of non-oil GDP andgrowth of oil price. Moreover in the short run the main determinants ofinflation rate are money growth and non oil GDP growth. In other study Pahlavani and Rahimi (2009) examines the majordeterminants of inflation in Iran by applying of annual time series data andARDL co-integration technique over the period of 1971 to 2006. In thisstudy empirical model has been specified according to Aljebrin (2006)which emphasizes the effects of liquidity, the exchange rate, GDP, theexpected rate of inflation and imported inflation factors on domesticinflation of Iran. The empirical results show that in the long-run, the maindeterminants of inflation in Iran are the liquidity, exchange rate, the rate ofexpected inflation and the rate of imported inflation. The impact of exchange rate unification on macroeconomic variables inIran has been investigated by Mohammadi & Gholami (2008) using VARtechnique. The main result from IRF1 and VD2 indicates that the shock fromexchange rate unification has a positive impact on the domestic inflation ofIran.

1- Impulse Response Function

2- Variance Decomposition86/ The Impacts of Unified Exchange Rate System on Domestic Price.

In other study by Mohammadi et al (1996) used a co-integration

approach, and concluded there is no long-run relationship between exchangerate and CPI in Iran. They argue that the main reason for lack of linkage between exchangerate and CPI is due to subsidies by the government on basic commodities,which are consumed by the majority of Iranian households. Furthermore,according to Bahmani-Oskooees discussion (2003), the devaluation ofIranian currency, rial has had an inflationary impact on the domestic price inIran. Then, he has concluded in order to counteract inflation not only shouldthe government follow tight monetary policy but also the foreign value ofrial should be strength by the exchange rate unification. Consequently, the past studies indicate that there is a linkage among theexchange rate, domestic price level, GDP, money supply and oil price. Thislinkage can be organized in the framework of an extended monetary modelfor Iranian economy and estimated by Johansens co-integration approachbased on VAR model. Before moving to the empirical methodology, two basic assumptionsare set up: i) Prior to the exchange rate unification, a proxy for unified exchangerate was defined which is a weighted average of official and parallelexchange rates. ii) The government maintains its subsidies to the different economicagents in such a way that the final consumers do not observe the cost effectfrom switching to the unified exchange rate. This means that the governmentstill subsidizes the consumers implicitly by paying the difference betweenthe market and official exchange rates, and still provides the basic importssuch as foodstuff and other essential goods at subsidized prices. However, inthe annual budget of the government, the real cost of the foreign exchange(the free market exchange rate) for the essential imports is recorded. These two assumptions are essential for validity of our conclusion. The unification of exchange rate in Iran in 2002 implies domesticcurrency devaluation where multiple exchange rates are unified to the levelof parallel exchange rate. So in order to evaluate impact of this currencydepreciation on the domestic price level at first in next section thetransmission mechanism of currency depreciation on the domestic pricewithin a theoretical model will be presented. Kazerooni, Ali Reza & Majid Feshari. /87

4- The Theoretical Framework and Econometric Methodology

4-1- Theoretical Framework The domestic inflation can be explained by several alternative theories.The Quantity Theory of Money is the first traditional theory whichhypothesizes the direct linkage between the money supply and price level ina closed economy. A new development in this stream of thought related tothe monetarist school headed by Milton Fridman. Friedman and Schwartz(1970), argue that inflation is always and everywhere a monetaryphenomenon. Whereas Neo-Keynesians and other critics of monetarismargue that the demand for money is directly linked to supply and that theDemand for money cannot be predicted. Stieglitz and Greenwald (2003)have proposed that the relationship between inflation and money supplygrowth cannot be separated for ordinary inflation, in contrast tohyperinflation, which is mostly considered an effect of monetary policy. Blinder (2002), a representative of the second school of thought, theKeynesian economists, states that the main determinants of inflation areaggregate demand in the economy rather than the money supply. According to the Keynesians, the natural level of gross domesticproduct is a level of GDP where the economy is at its optimal level ofproduction. If GDP increases beyond its natural level, inflation willaccelerate as suppliers increase their prices. If GDP decreases below itsnatural level, inflation will decelerate as suppliers attempt to fill excesscapacity by lowering prices. Keynes argued that money has no significantrelationship with inflation, but inflation is an outcome of the goods market(Pahlavani and Rahimi, 2009, P.63). However, in an open economy, in addition to direct impact of moneysupply on domestic price, the exchange rate fluctuations can contribute tothe domestic price movements. The degree of sensitivity of domestic pricesto the exchange rate changes has been examined by estimating the exchangerate pass-through to import, producer and consumer prices; the degree ofpass-through exchange rate changes has been considered as one of the mainsources of domestic inflation. In this context, the more important question isthe transmission mechanism through which, the exchange rate fluctuationsare transmitted to overall domestic price level. The aggregate demand andsupply channels reflects this mechanism.88/ The Impacts of Unified Exchange Rate System on Domestic Price.

Traditionally, the impact of exchange rate fluctuations on economy

mainly has been examined through the shift of aggregate demand because ofchanges on the net exports, demand for money, and level of output. Forinstance, the depreciation of domestic currency can stimulate economythrough increase in the aggregate demand components and leads to shift ofaggregate demand to right. However, the recent studies by Kandil (2004) suggest that the exchangerate fluctuations can also shifts the aggregate supply; especially, in the semiindustrialized countries which are overwhelmingly dependent on theimported intermediate goods for manufacturing. It means that depreciationof domestic currency can lead to higher cost of production and has acontractionary impact on the output level through shifting aggregate supplyto left and up with higher price. If the reduction in aggregate supply is more than offsets by the increasein aggregate demand, the depreciation will result in a reduction of domesticproduction. In this case, the depreciation is said to be contractionary.Otherwise, it could be expansionary. The final result depends on whicheffect is dominated. Generally, it could be argued that in less developed countries, theimpact of the aggregate supply channel dominates on that of the aggregatedemand channels and the economy faces the higher domestic price withlower output. Overall, it can be concluded that in an open economy, the domesticprice is jointly determined by money supply, exchange rate, aggregateoutput. In the oil exporting countries such as Iran, another explanatoryvariable, oil price as a exogenous variable can incorporate in this frameworkwhich has a negative impact on the price level through the providing moreforeign exchange reserves and more imports. Within this framework, the specification of the theoretical model withrespect to the impact of exchange rate unification on the domestic price ofIran can be identified according to Aljebrin (2006), and Pahlavani andRahimi (2009) works. The theoretical model can be stated as follows:

1 P = M E 2 GDP 3 OP 4 (1) Kazerooni, Ali Reza & Majid Feshari. /89

The Iranian experience from the past as mentioned before and paststudies confirm this systematic association among the exchange rate (ER),domestic price (P), real GDP (GDP), money supply (M), and oil price (OP).

4-2-Econometric Methodology The empirical methodology of this research is co-integration approachwhich is based on the VAR (Vector Auto- Regressive) model. A generalVAR model can be written as follows: kZt = i =1 Ai Z t i + t (2)

Where Z t is a column vector of all the variables t is a column vector

of the all error terms, A i is matrix of parameters in the model. A VARmodel can be considered as a reduced form of a structural model, where allof regressors on the right hand side of the equations are predeterminedlagged variables, which have no correlation with error terms. As a result, these equations can be estimated consistently by using

OLS.

In order to examine the impact of unified exchange rate on the domestic

been extracted from the 2007 annual statistical bulletin (OPEC) and theCentral Bank of Iran. Since the world oil price is determined in terms of US dollars and oil isthe main Iranian export (more than 80 percent of total export), most of theforeign exchange reserves of Iran is kept in dollars and a significant amountof foreign transactions are conducted in the terms of the U.S. dollar. For thisreason, the value of the U.S. dollar in terms of rial is considered as theforeign exchange rate. In the post-exchange rate unification period, themultiple exchange rates are unified to the level of floating exchange rate inthe free market. Under this assumption that the production of crude oil is stable in theshort run, index of oil revenues is presented by the oil price. The value of allvariables is explained in the logarithmic form to avoid the different scales ofmeasurement of the variables and to get a better behaviour of residuals in themodel.

5- Estimation Results The co-integration technique is based on the assumption that allvariables in the model are integrated of order 1. Therefore, at first, thevariables of the model (LP, LGDP, LWER, LOP, LM) must be tested forstationary using unit root test ADF (Augmented Dickey-Fuller) and PP(Philips-Perron) statistics. The unit root test is based on autoregressivefunction, which includes constant terms as well as a trend variable. Theresulting unit- root tests for the variables are tabulated in table 5.1

According to table 5.1, having established that the first difference of allvariables is stationary, I(1) by unit root test except LOP which is stationaryat the level, we proceed to test for co-integration between variables onlevels.

5-1- Johansen Co-integration Test

Before we run co-integration test, by using the Schwarz BayesianCriterion (SBC), the optimal lag length of 1 is determined for the VARsystem (Table5-2).

Table 5-2: VAR lag Order Selection Criteria.

Lag order SBC criteria

0 0.96 1 -7.66 2 -6.69

Source: Author Calculations

The results of the Max and trace test to identify the number of co-integrating vectors are reported in the table (5.3). According to both LR teststatistics ( Max and trace) the null of no co-integration is rejectedbecause both statistics are greater than their critical values. However the nullof at most one co-integrating vector cannot be rejected in favour of r=2.Thus the empirical support for one co-integration vector implies that all fourvariables, LWER, LGDP, LM, and LP are co-integrated.

Table 5-4: The Results of Normalized Co-integrating Equation by LP

The sign of the coefficients of co-integrating equation is consistent with

of a priory expectation that the weighted exchange rate (LWER) and moneysupply (LM) have a positive and real GDP (LGDP) has a negative effectrespectively on the domestic price level. After confirming the long-run relationship among the variables, we canproceed to the model that relates the short-run adjustments behaviour ofvariables to the long-run path. More specifically ECM model explains the immediate short-runchanges in dependent variable by means of deviations from particularequilibrium relationship between the dependent variable and the explanatoryvariables. The common approach is to reformulate the long-run relationshipto include lagged values of first differences in the relevant variables with theerror correction term explicitly included. The result of ECM model presented in table (5.5) suggests that theestimated value of error correction coefficient -0.32 is statistically significantat 5% level and indicates convergence to equilibrium in right direction. Kazerooni, Ali Reza & Majid Feshari. /93

Variables Coefficient t statistics

Source: Author Calculations.

*: Significant at 5% level.

6- Conclusions and policy implications

As earlier indicated, the basic aim of this research was to find out theimpact of exchange rate unification on the domestic price level in Iran byusing co-integration approach. As ADF and PP tests have shown the time series of all variables exceptthat of oil price are non-stationary of order one, I (1). Furthermore, usingJohansens co-integration technique confirms a long run relationship amongthe variables LP, LWER, LGDP and LM. In this co-integrating regression function, the weighted exchange ratehas a positive impact on the domestic price. Regarding to policyimplications, the macroeconomic results show that depreciation of Iraniancurrency under flexible and unified exchange rate system may createdomestic inflationary pressure and highlight the inflationary expectations.Since the money supply has a positive impact on the domestic price,therefore the government should avoid the easy money policy in order tocontrol inflation (follow a disciplinary financial policy where the budgetdeficit is tighten and does not rely on expansion of monetary base) whilepursuing unified exchange rate policy. This leads to the situation where theunified exchange rate is accompanied with stabilized exchange rate.94/ The Impacts of Unified Exchange Rate System on Domestic Price.

Finally, the depreciation of Iranian currency which has resulted from

unified exchange rate could lead to more exports and less imports andconsequently stimulate more domestic output which itself stabilizesdomestic prices. In order for domestic output to be sensitive to thefluctuation in the exchange rate, the productive capacity of Iran should bemore responsive to the exchange rate, so Iran should overcome someeconomic bottlenecks such as lack of strong infrastructures, includingvocational trainings, skilled manpower and entrepreneurship, backwardnessof the agricultural sector and the obsolete industrial units. It means that theunified exchange rate plan would be accomplished with less domesticinflation.